They’re Not Making Any More of It
Many of our clients own significant interests in real property, both on Long Island and in New York City. Some of these clients are more active investors than others. They may engage in like-kind exchanges in order to diversify their holdings. They may enter into relatively complex joint ventures with other investors. They may spin-off parts of their portfolios in order to obtain better financing, or to address management or ownership issues.
In every case, they are keen on reducing any tax liability that may otherwise be incurred as a result of the particular transaction. After all, they want to maximize the economic return on their investment. The more that they pay in taxes as a result of a particular investment or transaction structure, the lower their economic return will be.
A Recent Development
A recent decision by N.Y.’s Division of Tax Appeals may be of particular interest to real estate investors and their advisers. In this case, an Administrative Law Judge (the “Court”) considered whether the real estate transfer tax (“RETT”) was properly asserted in the transactions described below.
Taxpayer and Partner acquired real property (the “Property”) in N.Y.C. as tenants-in-common (“TIC”). Upon acquisition, Taxpayer held an undivided 45% TIC fee interest in the Property and Partner held an undivided 55% TIC fee interest in the Property. RETT was paid in connection with the acquisition of the Property.
Approximately three-and-one-half years later, Taxpayer and Partner formed Owner LLC.
On Date 1, one week after the creation of the LLC, Taxpayer and Partner contributed their respective 45% and 55% TIC interests in the Property to Owner LLC, in exchange for which Taxpayer received a 45% membership interest in Owner LLC, and Partner received a 55% membership interest.
Immediately thereafter, and on the same day, Taxpayer sold its 45% membership interest in Owner LLC to Partner in exchange for approximately $111 million.
Taxpayer and Partner filed a New York State Combined Real Estate Transfer Tax Return (Form TP-584) reporting the contribution of Taxpayer’s fee interest to Owner LLC, and the sale to Partner of Taxpayer’s membership interest in Owner LLC. Both transfers were reported as tax-exempt transactions: (i) the contribution of Taxpayer’s fee interest to Owner LLC as a conveyance that consisted of a mere change of identity or form of ownership or organization; (ii) the sale of Taxpayer’s 45% membership interest to Partner as the transfer of a less-than-controlling interest.
The Parties’ Positions
New York (the “State”) audited Taxpayer in connection with these real estate transactions. Based on its findings, the State asserted that Taxpayer was liable for RETT, plus interest and penalties.
Taxpayer filed a Request for Conciliation Conference with the Bureau of Conciliation and Mediation Services (“BCMS”), but BCMS issued a conciliation order that upheld the tax assessment.
Taxpayer then filed a petition with the Division of Tax Appeals, where it contended that the State erred in asserting a tax deficiency because Taxpayer’s and Partner’s contributions of their respective interests in the Property to Owner LLC on Date 1 were each exempt from RETT as a “mere change in form.”
Taxpayer also contended that its “subsequent” sale of its 45% membership interest in Owner LLC to Partner, also on Date 1, was not subject to RETT because it did not constitute a transfer of a controlling interest in an entity that owned real property.
The State contended that, with the transfer of Taxpayer’s 45% interest in Owner LLC to Partner, Partner obtained a 100% controlling economic interest in the Property, which resulted in a 55% nontaxable mere change in ownership and a 45% taxable change in beneficial ownership.
The Court explained that RETT was “imposed on each conveyance of real property or interest therein.” All conveyances were presumed subject to the tax, it stated, until the contrary was proven, and the burden of proving the contrary was on the taxpayer responsible for the tax.
The term “conveyance,” it continued, is defined as “the transfer or transfers of any interest in real property by any method, including but not limited to sale, exchange, . . . or transfer or acquisition of a controlling interest in any entity with an interest in real property.” The term “controlling interest,” in turn, is defined, in the case of a partnership, as “fifty percent or more of the capital, profits or beneficial interest in such partnership . . .”
However, even where a transfer constitutes a “conveyance,” RETT does not apply to the extent that the conveyance effectuates “a mere change of identity or form of ownership or organization,” without a change in beneficial ownership.
The State conceded that Taxpayer’s and Partner’s contributions of their respective TIC interests in the Property to Owner LLC in exchange for membership interests in Owner LLC, standing alone, were exempt from the RETT as mere changes in form of ownership.
The State argued, however, that because of the subsequent sale of Taxpayer’s 45% membership interest to Partner, the combined transactions became subject to RETT. According to the State, “[i]t is [Taxpayer’s] sale of its 45% interest in Owner LLC to [Partner] in aggregation with [their] conveyances of their interests in the [Property] to Owner LLC, and the RETT implications of aggregating those transactions, that are at issue in this case.”
The State attempted to “aggregate” what the Court stated were “three nontaxable transactions,” namely (1) the transaction between Partner and Owner LLC, which effectuated a mere change in form of ownership, (2) the transaction between Taxpayer and Owner LLC, which also effectuated a mere change, and (3) Taxpayer’s transfer of its 45% membership interest in Owner LLC to Partner, in order to impose RETT on the transfer of this 45% interest.
The Court rejected this attempt, pointing out that the third transaction did not meet the definition of a transfer of a “controlling interest” because Taxpayer did not sell more than 50% of Owner LLC. As such, that transaction, by definition, could not be considered a transfer or acquisition of a controlling interest in an entity with an interest in real property.
The State nevertheless contended that adding the transfer of Taxpayer’s 45% interest in Owner LLC with Partner’s 55% interest in Owner LLC resulted in Partner’s “acquisition” of a controlling interest in Owner LLC. In support of its position, the State pointed to the RETT regulations, which provide:
“Where there is a transfer or acquisition of an interest in an entity that has an
interest in real property, . . . , and subsequently there is a transfer or acquisition of an additional interest or interests in the same entity, the transfers or acquisitions will be added together to determine if a transfer or acquisition of a controlling interest has occurred. Where there is a transfer or acquisition or a controlling interest in an entity . . . , and [RETT] is paid on that transfer or acquisition and there is a subsequent transfer or acquisition of an additional interest in the same entity, it is considered that a second transfer or acquisition of a controlling interest has occurred which is subject to [RETT].”
While the Court acknowledged that the regulation provides for adding together multiple transfers or acquisitions of interests in an LLC with an interest in real property to determine if a transfer or acquisition of a controlling interest has occurred, it also noted, contrary to the State’s argument, that the regulation does not authorize or provide for adding such a transfer or acquisition together with a nontaxable “mere change in form of ownership” conveyance in order to achieve a taxable transaction.
The regulation provides that aggregation applies to multiple transfers or acquisitions of interests in an entity with an interest in real properly that occur within a three-year period. The “fallacy of the State’s argument for aggregation,” the Court continued, was that the initial transaction between Partner and Owner LLC, wherein Partner exchanged its 55% TIC interest in the Property for a 55% interest in Owner LLC was not a “transfer or acquisition of an interest in an entity with an interest in real property.” Rather, it was a mere change in the form of ownership of the Property. Since the transaction between Partner and Owner LLC was not a transfer or acquisition of an interest in an entity, that transaction could not be aggregated with Taxpayer’s subsequent transfer of a non-controlling interest.
The Court then noted that, under the above regulation, where there is a transfer or acquisition of a controlling interest in an entity with an interest in real property, “and [RETT] is paid on that transfer or acquisition,” followed by a subsequent transfer or acquisition of an additional interest in the same entity within three years, “it is considered that a second transfer or acquisition of a controlling interest has occurred which is subject to [RETT].” Because the initial transfer between Partner and Owner LLC was not a transfer or acquisition of a controlling interest, but merely a change in form of ownership, no RETT was required to be paid. The State’s argument that the subsequent transfer of Taxpayer’s 45% interest to Partner was considered a second transfer or acquisition of a controlling interest that was subject to the RETT ignored the language of the regulation requiring that RETT was paid on the initial transaction for aggregation to apply.
Thus, the Court concluded that Taxpayer did not owe any RETT as a result of the above transactions.
Did the Court Get It Right? Did the State?
There is no doubt that if Taxpayer had sold its 45% TIC fee interest (not a partnership interest) to Partner, the sale would have been subject to RETT, and Partner would have become the sole owner of the Property.
However, nowhere in its opinion does the Court describe the nature of the TIC arrangement between Taxpayer and Partner for income tax purposes. Did it represent a mere co-ownership of property that was maintained, kept in repair, and leased, and did not constitute a separate entity for federal tax purposes?
Or did the TIC owners treat their arrangement as that of a partnership, for which they filed partnership income tax returns and received K-1s? If they had, then the Court would likely have reached the same conclusion as above, without regard to the contribution of the Property to Owner LLC – rather, it would have based its decision solely on Taxpayer’s not having transferred a controlling interest in a partnership.
But in that case, neither the Court nor Taxpayer would have had to rely upon the “mere change” exemption. For example, see N.Y.’s Limited Liability Company law, which provides, in the case of the conversion of a partnership into an LLC, that all the real property of the converting partnership remains vested in the converting LLC – in other words, there is no “conveyance.”
Enter Owner LLC. Why was it needed? In form, it represented a partnership: a non-corporate business entity with two members.
But can we say that this “partnership” had any substance? It was funded by Taxpayer and Partner on Date 1 (after having been formed only one week earlier), and Taxpayer also sold its newly acquired membership interest in LLC to Partner on Date 1 – presumably pursuant to an earlier binding agreement – following which Partner owned 100% of Owner LLC and the Property.
Although it appears that the parties utilized Owner LLC for the sole purpose of characterizing Taxpayer’s sale of its LLC interest to Partner as a transfer of a non-controlling interest, the State does not appear to have argued that the substance of the above transactions should have determined their RETT consequences.
The State will likely appeal this decision – indeed, it should. Until it does, and unless the Appellate Division agrees with it, taxpayers may have been given a simple way to circumvent the otherwise taxable transfer of a TIC interest.